How Intangible Assets Affect Business Value

When pricing your business for sale, intangible assets can be even more important than tangible property.

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May 6, 2002

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Q: I'm considering selling my business. Over the course of more than a decade, my business's name and logo have become well-known within the local community. How is this community awareness taken into consideration when pricing my business for sale?

A: Customer awareness and a prominent position within the marketplace are key ingredients to the success of many businesses, both small and large. The value placed on intangibles assets, such as people, knowledge, relationships and intellectual property, is now a greater proportion of the total value of most businesses than is the value of tangible assets, such as machinery and equipment. And the creation and management of intangible assets is often essential to long-term success.

A strong brand and a loyal customer base can be distinct assets owned by a business or simply part of a business's goodwill. Examples of distinct intangible assets include copyrights or trademarks that let a business sell its products for a higher price or in greater quantity than its competition, proprietary mailing lists of customers or prospects, long-term contracts, and franchises with long track records and well-recognized names. Goodwill is defined as the value of the business in excess of its owner's equity; examples include a favorable location and community awareness.

As important as these assets are, most business owners do not have an adequate understanding of how their brand and customer bases impact the value of their businesses. Rule-of-thumb formulas do exist in some industries, but a better estimate of value is gained through a more in-depth analysis. Brands can be valued using three traditional valuation approaches: cost, market and income.

The cost (or cost of creation) approach relies on calculating what it would cost another business to duplicate a given asset today. This can be done using an estimation of current costs or by calculating the present value of all historical expenses of creating the brand.

The market approach focuses on past sale transactions of brand names. As expected, finding good data to use as a comparison is very difficult. However, if you're able to identify a brand that's comparable to your brand name and use it as a proxy, the market-based valuation analysis is quite reliable.

The income method measures the future benefits (such as sales, profits or cost savings) that the intangible asset will bring to a business, the timing of the receipt of those benefits and the length of time that the business will receive those benefits. Generally, a combination of a discounted cash-flow model and an excess earnings method is used to establish value under the income approach. A variation of this approach is to calculate and capitalize the profits generated by your business with the strong brand name that are in excess of a similar "unbranded" business.

In valuing your loyal customer base, it's important to remember the 80/20 rule of thumb: that 20 percent of your customers most likely produce 80 percent of your profits. Generally, the best method to valuing a customer base is to segment your customers into categories based on characteristics that drive profitability. For example, frequency and dollar amount of purchases or longevity of relationship may be pertinent metrics. Using this data, a lifetime customer value may be calculated as the present value result of the average profit per purchase multiplied by the number of purchases per period multiplied by the length of the relationship. This information will prove useful not only in calculating a value for your customers, but also in focusing your sales efforts on your most profitable customers.

A useful, though less-scientific, way to combine the analysis of your brand and your customers is to consider customers' awareness, loyalty and quality perception of your brand. Perceived quality has the strongest linkage to strong profitability, usually because quality brands can demand a price premium.

Customers' loyalty in purchasing is the number-one value-creating factor in brand valuation because it results in an even and predictable revenue stream. Loyalty can also be further categorized into non-customers, price-switchers, passively loyal, fence-sitters and committed customer groups.

In the end, brand recognition and customer loyalty are very important components of the value of your business. The realization of this value is through increased earnings that are received steadily over a period of time. You must understand this value, manage it in your business and convey that understanding to potential buyers. The better you perform these tasks, the higher a premium you'll receive for these intangible assets upon selling the business.

Edward Karstetter is the Director of Valuation Services at USBX, a middle market investment bank. His practice provides a comprehensive range of valuation and financial advisory services to privately held and publicly traded clients. During his career, Karstetter has worked on more than 100 valuations and M&A transactions, totaling more than $4 billion.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.